Multiple equilibria

A simple model of growth crises

TYLER COWEN says he "still [does] not believe that the Chinese 'recovery' is for real". He quotes a recent Financial Timesstory, which reads in part:

Chinese credit issuance surged to a record high in January on the back of a boom in shadow banking, stoking concerns that the economy could overheat.

And he adds:

I will admit, at the very least, to needing to revise my views on how often the fires can be restoked. I had been expecting 3 to 5 percent “real growth” for China in 2012.

Mr Cowen goes on to cite some interesting new estimates of Chinese growth for 2011 and 2012. One, by Standard Chartered economist Stephen Green, suggests that the economy expanded by just 7.2% in 2011 and 5.5% in 2012.

What exactly is Mr Cowen worried about? Well, there are plenty of ways for an economy in China's position to fail. One, and this may be Mr Cowen's worry, is to squander resources needed to secure future growth. China, in other words, may be misdirecting investment in an effort to prop up growth, leading to a corresponding underinvestment in public goods needed to maintain future growth and development. Future growth might then prove disappointing, leading to downward revisions of assessments of China's ability to service public and private debts, thereby sparking a period of stagnation or crisis.

I don't know how much to fear such things. Is China actually skimping on important investments in favour of bad ones? Or is it merely repressing consumption? I'm not sure that the latter implies slower future growth (relative to an "ideal" investment scenario). It's also quite possible that some meaningful share of current investment is "quasi-consumption": spending that looks like investment but which is actually there to deliver consumer services that would normally be considered consumption. Depending on how much quasi-consumption there is, both China's investment share and its return on investment look worse than they actually are.

There is no question that China's financial system is incredibly distorted. And it seems clear that China's economy will eventually need to "rebalance", so that consumption represents a larger share of output. Rebalancing will almost certainly entail or correspond to slowing growth. It isn't clear, however, that this has to be a painful process. A rising consumption share can mean that households feel better and better even as headline growth slows. Perhaps there will be lots of bad debts. But it is hard to imagine them outstripping the ability of the Chinese economy to manage them. Official public debt as a share of the economy is remarkably low. Growth and seignorage will also help. But still, there is some reason for concern.

So we have one possible story of Chinese trouble. Now let's imagine another. Let's say China has been growing like mad, a successful catch-up story. But we all know Chinese growth must slow eventually as it runs out of opportunities for easy catch-up: such as urbanisation of the rural population and adoption of Western technology. Many argue that China has already passed that point and that recent growth is in large part "artificial", down to the stoking of unsustainable and potentially dangerous financial fires. To try and maintain nominal growth, some officials worry, would allow the bubble to inflate even further. It would fuel moral hazard, by convincing state and private business as well as enterprising local party leaders that the government will never let growth weaken, never force everyone to "face the consequences" of their bad loans. And so eventually the worried government gives up on stoking the fire. Lo and behold, growth collapses. As growth collapses the "true" picture of financial excess emerges as bad debts emerge everywhere, even in places that looked reasonably sound before the crash. The outlook for future growth suddenly dims, suddenly weighed down by the combined drag of demographics, depression, and debt. The doomsayers will have seemed to have been right all along.

But were they? Here's what I believe. China's real growth rate will slow. If China seeks to maintain historical rates of real growth, then inflation will accelerate. If inflation is accelerating then the economy is overheating; the government is pushing it to grow faster than it can manage. To avoid this, China's government will have to accept a lower rate of overall growth (and indeed, the official numbers indicate that this acceptance is occurring). When Chinese growth slows, some (and maybe a lot) of the bets made on Chinese expansion will go bad. Depending on how these losses are handled, some people will lose out from the slowdown. Others will come out all right. But there is a risk that China's government will come to believe that bad bets and financial excess necessarily imply economic overheating. It may preemptively act to "prevent the bubble from getting out of hand", reining in credit and economic growth. Because loan outcomes are contingent on the state of the economy, this will necessarily mean that lots of loans will go bad (including some that might not have otherwise). The combination of slow growth and financial losses will seemingly ratify the conclusion that China's economy was built on unsustainable excess. But in fact, the Chinese government will have merely shifted the economy from one possible equilibrium to another.

There is a lot we don't know about the Chinese economy. It will face significant challenges in coming years. It is worth remembering, though, that one of the biggest potential threats is that the government, worried about financial excess, will tighten policy too much, in the process generating the economic disaster it hoped to avoid. It's very reasonable to wring our hands over dodgy looking investment. But we should also keep in mind that there are worse things in the world than credit-market overheating.

Quasi-consumption is really quite unlike real consumption. Normally when you consume something, you are conscious of what you're consuming. If you buy a television, it's because you want to watch television. You might opt for a top-of-the-line model because of you're a TV junkie. It costs more, but your personal needs and desires make it worth every dollar. On the other hand, if you're only an occasional TV viewer, you would probably choose to buy a more modest model. This form of consumption is stable. It's largely immune to external factors. The stock-market might be tanking and the state going bankrupt, but guess what, you're still a TV junkie. Unless you're watching Girls on a 80" set, you would simply die. You'd buy the expensive television no matter what, resorting to borrowing if necessary.

Now, imagine people suddenly believing that televisions are investments. The purchasing pattern is completely different. Everyone is going to buy the most expensive set possible--even the blind--in hope of gaining a return. That's quasi-consumption: consumption that's predicated on a mistaken belief. It's irrational and hence unstable. A correction will come eventually and it's irreversible. Once you have seen, you cannot unsee. Once you realized, you cannot unrealize. Once you know that cow pie is not made of beef, nothing will induce you keep eating it.

Interesting post.
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Trying to figure out China, its economy, and likely gov't action, reminds me of what Churchill said about Russia pre-WW II -
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"I cannot forecast to you the action of Russia. It is a riddle wrapped in a mystery inside an enigma, but perhaps there is a key. That key is Russian national interest."

You just have to hope, in the face of evidence to the contrary, that you are one of those rare few who metabolize the alcohol without after-effects. Pity there is so much historical evidence that China isn't one.

If I'm correct, I believe that the assets of the Chinese banking system have exploded over the past 5-7 years. From various estimates that I've seen, I've seen projections that the size of the largest Chinese banks to be twice as large as the largest US banks. Also, the non-performing loans(NPLs) of the Chinese banking system have fallen from around 19% to <1% from 2001-2011. Their loans are also expected to grow at a rate of 10-20% over the next few year. Right now, we've witnessed a drop in NPLs combined with massive growth in commercial real estate and a massive growth in their banking system. This seems like a classic bubble.

RA got it about right. These are signals (not noises) of what can turn into a hard landing. Chinese Govt got it right in turning the economy to be consumption based given the end of cheap manufacturing, slowdown in global demands, competition from others (eg Vietnam, Indonesia) in supply of cheap labor. However, implementation is the issue. Too much vested interests that retard the shift towards consumption based economy. With its vast foreign reserves, China still has an arsenal of monetary policy tools. But these will be band aids and like in the recent crisis, much wasted. Quality growth from a service based economy will take years to build given its pathetic infrastructure of law and software skills. Wishful thinking that the global economy stand still for China to get its act together by the bureaucrats.

Watch real estate prices. As in East and South East Asia, there appears to be a bubble in China property prices. When these finally turn down there could be a property price crash and banks with unrecoverable debts.

That is why governments are deperately trying to cool the real estate market because more than anything else they fear the collapse of property prices and the political consequences of a crash.

A war in Korea/Senkaku/Spratlys could be the straw that breaks the camel's back.

Hows the leader will dominate & eradicate the corruption in China. This is a big factor to play the economic sector also.Of course, china's move to high tech production to add another jump in economy. Population, dedication & plan of China are the key factors of keeping the growth too.